Fit for a King

Mervyn King, governor of the Bank of England, finally comes out and tells it (more or less) like it is. Bless him. In a speech to businessmen in Edinburgh, Mr King observes that the Anglo-Saxon financial system has so far been bailed out, to the tune of trillions of dollars, with no fundamental change in the way the banking system operates. Huge bonuses will again be paid to bankers this year-end, despite the fact their earnings depend on a limitless supply of almost free taxpayer money. We give them free money, they make a profit: clever stuff.

Mr King suggests this is unfair, paraphrasing Churchill: ‘never in the field of financial endeavour has so much money been owed by so few to so many,’ he says. The solution turns out to be the same one that people like the governor figured out 80 years ago, in the wake of the Great Crash. The retail and investment functions of banking need to be separated, so that speculative activity by investment bankers faces a serious prospect of punishment by bankruptcy when things go wrong. When every kind of financial function is merged under one roof, this does not happen. In the latest crash: ‘Banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them,’ says Mr King. ‘And they were right.’

Of course Mr King does not mention America’s Glass-Steagall Act of 1933, which split banking functions in order to ring-fence speculative activities. That would be tantamount to admitting that banking regulators have not learned anything for the best part of a century. But his logic is exactly that of Glass-Steagall when he describes banking functions that are necessary to the community and those which are simply a matter of private speculation: ‘The banking system provides two crucial services to the rest of the economy: providing companies and households a ready means by which they can make payments for goods and services and intermediating flows of savings to finance investment,’ says Mr King (he could have put the second point more clearly by saying that banks, uniquely, provide working capital to industry). ‘Those are the utility aspects of banking where we all have a common interest in ensuring continuity of service,’ he goes on. ‘And for this reason they are quite different in nature from some of the riskier financial activities that banks undertake, such as proprietary trading.’

Mr King’s reflections on the financial crisis are about as candid and thoughtful as anyone connected with government in the UK or the US has managed in the past year. He is quickly supported by a forceful opinion piece from Martin Wolf in the Financial Times. Sadly, however, it is highly unlikely that there will be a new Glass-Steagall Act on either side of the Atlantic. The senior economic advisers to the Anglo-Saxon governments, whether Fat Larry Summers or Alastair ‘Hello’ Darling, are far too spineless and mired in the mathematical drivel of ‘modern’ economic theory. There will be an incremental regulatory ‘solution’ to the financial system’s instability, involving new rules relating to capital adequacy. This has been tried for decades, and does not work because banks’ prudential requirements for capital vary over the economic cycle and cannot be reduced to a workable regulatory formula. Still, there will be lots of new jobs for regulators until the next financial crisis.

A simple, radical solution, as Mr King recognises, is what is actually needed. It should not be embarrassing to admit that what people figured out in the 1930s is better than what their successors thought in the 1990s (when Glass-Steagall was finally repealed under Bill ‘Mind-On-Other-Things’ Clinton).

Moreover, there is one new thing that governments could do to stop the cycle of ever more severe financial crises that has afflicted the world since the end of the Bretton Woods fixed exchange rate system in 1971. There is not a hope in hell that this change will be discussed, let alone happen, but it is worth mentioning. The change is simple: end the absurd tax treatment of corporate debt, whereby interest on debt is deductible as a business expense before taxes are paid. This is not the case with equity, where dividends have to be paid after tax. The contrasting, and logically indefensible treatment of debt and equity in contemporary tax systems first encourages companies (including banks) to load up on debt, and second discourages the creation of more employee-owned firms. It is one of those things that is so dumb, so fundamentally wrong, that it is not even discussed.